Strengthening College Endowments Using Life Insurance Premium Finance

Tim Goral's picture
Wednesday, August 15, 2012

Over the last few years, my colleagues and I have developed an expertise in a specialty that is often misunderstood: Life Insurance Premium Finance. While this technique has been in existence for almost 20 years, it is not readily available at large private banks or brokerage firms. Banks lend into this market, but there are only a handful of boutiques that have the experience and knowledge to design and monitor premium-financed policies.

My firm’s interest in Life Insurance Premium Finance emanated from a desire to better serve our clients-- many of whom have a sizeable net worth. When constructing financial plans for the wealthy, the exercise often leads to the purchase of life insurance for estate liquidity and other purposes. We have come to learn that even the very rich find it distasteful to have to liquidate well-performing assets to cover premium checks that can amount to several hundred thousand dollars or more a year. Life Insurance Premium Finance has proven to be a welcome and beneficial solution for many of them. In fact, one of our strategic partners has done over $30 billion (face amount) of this business for families of wealth since 1995.

A Novel Idea

Last year one of my partners, David W. Johnson, had a thought: How could Life Insurance Premium Finance be used to assist institutions of higher education in raising funds for their endowments? The few firms that have assembled premium-financed life polices in the past have only done so in the high net worth, “key man” and “buy/sell” marketplaces.

David is knowledgeable about, and sensitive to, the needs of college endowments. He has spent the last decade serving as a trustee of two small colleges in Alabama and New Jersey and often cites the ongoing attempts by those institutions to raise funds for very worthy causes. Many schools, of course, are confronted with a never ending and arduous task of seeking funding. David felt that new and constructive ideas in this field were needed. We have since concluded that in many instances Life Insurance Premium Finance could be an attractive option for many colleges and their endowments.

Leveraging Endowment Capital

A one-size fits all approach does not work in Life Insurance Premium Finance for wealthy individuals or colleges. Each case is unique and depends on available resources of the college and its stated goals and objectives. With that said, this article will attempt to enlighten college trustees, CEOs, CFOs, Development Officers and other interested parties who are willing to consider new funding sources for their endowments. It will also identify the essential ingredients to experience a successful premium-financed outcome.

The Process

  • Engaging competent tax counsel from the beginning is always helpful. The CEO, CFO and Development Officer of the college need to work together.
  • The college establishes an IRC Section 501(c)(3), a fully tax-exempt Supporting Organization. (“SO”). It will be a bankruptcy remote vehicle.
  • Friends of the college, alumni and/or certain school employees consent to having the SO purchase universal life insurance policies on their lives. The SO must have an “insurable interest” in each of these individuals who, ideally, should be between 25 and 55 years of age. Physical examinations are required. The face amounts of the policies might range from $250,000 to $1 million or more depending on the financial status of the individual and other factors. Each fund raising effort needs to involve a minimum of $10-15 million (face amount) of insurance to obtain attractive financing terms.
  • The SO borrows funds from a pre-selected bank or other financial institution to pay the premiums on the policies. Loans are typically priced at 1 ½-2% over LIBOR. Interest on the loan is capitalized (but does not have to be).
  • In consideration for extending the loan to the SO the financial institution receives collateral in two forms: (1) the cash value of the policies is assigned to it, and (2) to the extent the policy values are less than the amount of the loan (which is generally the case in the first 3-4 years of the policy), one or more securities accounts are pledged to the lender by the college and/or friends of the college to cover the “gap”. Standby letters of credit can also be used. When there is no longer a “gap” the collateral is released to those who pledged it. At that time, the collateral is free to be used to support another plan.
  • The insurers that underwrite the policies are usually among the top ten largest in the US. Indexed Universal Life policies are often purchased. These policies can have “caps” providing a 0% floor and 85% or so of the upside of a given equity index such as the S&P 500. If, for example, the S&P 500 index is down 10%, the policy is credited with zero that year. If the index is up the following year by 20%, the policy is credited with 17%. The amount credited to a policy cannot be reduced due to fluctuations in the index (market). There is also a fixed income account which can be used to grow the policy cash values.
  • In approximately year 14-16, the cash value of policies will be sufficiently large to enable the loan balances to be repaid. The policies can continue to grow. Loans against the policies can be taken by the SO for immediate cash needs and deposited into the endowment. As the insureds pass on, the death payments of the policies are paid to the SO and then credited to the endowment. Plans are designed with the assumption that no one dies prior to age 85. Premature deaths, of course, would only enhance the returns on the policies.

The SO Process chart

It is worth reiterating that each case is different and the above outline is just one way of proceeding. An illustration of the cash flows, need for collateral, internal rates of return and other important details of a plan are generated based on a college’s census data and reasonable assumptions. The number of insureds, providers of the collateral, amounts of the policies and their individual design and performances will vary from one SO plan to another.

In some instances, individual plans will be more appropriate than group structures. While we are, in many respects, pioneers in introducing the life insurance premium finance concept to the college endowment community, we have already experienced making very different proposals to dissimilar schools. In one case, the focus was on insuring its wealthy benefactors. The other involved a group plan with tenured professors, trustees and employees of the college. Sometimes we recommended that the school provide the needed collateral. In others, the insureds or benefactors of the school would do so. One plan called for the interest on the loans to be paid annually. In many instances, the interest can be capitalized.

The Risks

There are risks involved with Life Insurance Premium Finance. But that is true with most any financial transaction. The risks, however, are manageable. If they were not, the major money center banks would not be so anxious to lend into this market at such relatively low rates.

The principal risks in financing premiums are rising interest rates and the overall performance of the policies. For this reason, it is important that these policies are “stress tested” in advance and that the historical arbitrage between LIBOR and the index(s) being used is thoroughly understood. The choices of indices are many-- both fixed and equity-based. Those responsible for administering the college endowment need to become comfortable with the risk/reward proposition associated with premium finance.

Insurable Interest and Collateral

The key ingredients in organizing these programs are (1) gathering enough employees, alumni and friends of the college to, in effect, gift a portion of their insurability, (2) assembling from the college, alumni and/or friends of the institution sufficient collateral to cover the relatively short-term “gap” between the loan amounts and the cash value of the policies. (The pledger of the collateral remains its beneficial owner and continues to receive interest and dividends from the portfolio), and (3) establishing that the college has an “insurable interest” on each of the insureds in the plan. Past donors, for example, normally qualify. Tenured professors and senior administrators also generally meet the definition of individuals in which the college could have an “insurable interest”. The reasoning: To replace them could be expensive and time consuming.

Our experience is that many people have excess insurability they will never use. Getting them to donate some of it to a worthy cause is usually not too difficult. The requirement of a physical examination can sometimes be challenging. Yet the mission is certainly attainable with an ancillary benefit to the individual. As a general rule, the insurability of an individual approximates his or her net worth.

The college is often the lender of the needed collateral to cover the “gap” that arises in the first 3-4 years of a plan. If the college does not have sufficient collateral, borrowing it from wealthy friends of the school is often practicable. The peak collateral needed to cover the “gap” on a $10 million transaction would approximate $1 million or 10% of the death benefit. The numbers are generally linear i.e. a $50 million plan would require peak collateral of about $5 million.

Politics

Our experience, and that of our various partners, is that the biggest obstacle to structuring plans for institutions can be the involvement of too many people. A lack of financial perspicacity and/or decision-making authority can impede or even derail sagacious opportunities. A judicious and well-organized campaign by the college’s CEO, CFO and Development Officer, can help avoid many of these potential difficulties.

Conclusion

An innovative and thoughtful approach to raising funds for endowments merits serious consideration by many schools, especially when it can involve little, if any, out of pocket expenses or risk to them. Much of what has worked in the Wealth Management world can be effectively implemented to assist college endowments in their continuous fund raising efforts.

A properly organized and instituted program to friends of the college, its employees and alumni can elicit considerable support. Once contributions of insurability have been secured, “insurable interest” established, and arrangements for the short-term borrowing of collateral made, these plans are able to generate meaningful cash flows with high internal rates of return for many years.

Kevin B. Murphy is Managing Director of Johnson & Murphy Wealth Advisors, LLC with offices in Bedminster, NJ and Naples, FL. He is also President & CEO of Johnson & Murphy Insurance Services, LLC. Kevin can be reached at Kevin@JMWAdvisors.com or 908-719-3025. Also see: JMWAdvisors.com and LifeInsurancePremiumFinance.Org

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